INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT Lecture 2: The International Monetary System: Foreign Exchange Regimes

What is the International Monetary System? It is the overall financial environment in which global businesses operate. It is represented by the following: International Money and Capital Markets Banking markets Bond markets Equity markets Foreign Exchange Markets Currency markets (and foreign exchange regimes) Derivatives Markets Forwards, futures, options…

Concept of an Exchange Rate Regime The exchange rate regime utilized by any country refers to the arrangement by which the price of country’s currency is determined within foreign exchange markets. This arrangement is determined by individual governments! Foreign currency price is: The foreign exchange rate (“spot rate”). Expresses the value of a county’s currency as a ratio of some other country. Target currency (or common denominator) has historically (since the 1940s) been the U.S. dollar.

Why are Exchange Rate Regimes Important for Global Firms? Exchange rate regimes will determine the pattern and potential volatility of the movement of a country’s exchange rate. Exchange rate changes are important because they: Affect the competitive position of global firms Especially true for exporting firms Affect the cost structure of global firms Especially true for importing firms Affect the profit structure of global firms Overseas subsidiaries, exporters, and importers. In short: affect the “financial performance” of a global firm.

Foreign Exchange Rate Quotations There are two generally accepted ways of quoting a currency’s foreign exchange rate. American terms quote: The amount of U.S. dollars per 1 unit of a foreign currency. For Example: $1.90 per 1 British pound European terms quote: The amount of a foreign currency per 1 U.S. dollar For Example: 115 yen per 1 U.S. dollar Most of the world’s major currencies are quoted on the basis of American terms, but the majority of the world’s currencies are quoted on the basis of European terms.

Exchange Rate Regimes Today Current exchange rate regimes fall along a spectrum as represented by national government involvement in affecting (managing) the exchange rate for their currency. No Involvement by Government Very Active Involvement by Government Market forces are Determining Exchange rate Government is Determining or Managing the Exchange rate

Exchange Rate Regimes Today No Involvement by Government Very Active Involvement by Government Market forces are Determining Exchange rate Government is Determining or Managing the Exchange rate Managed Rate “Dirty Float” Pegged Rate Floating Rates

Classification of Exchange Rate Regimes Floating Currency Regime: No (or minimal) government involvement in foreign exchange markets Market forces – i.e., demand and supply – determine foreign exchange rate (price). Managed Currency (“dirty float”) Regime: High degree of intervention of government in foreign exchange market. Purpose: to offset “undesirable” market forces and produce “desirable” exchange rate. Usually done because exchange rate is seen as important to the national economy (e.g., export sector).

Classification of Exchange Rate Regimes Pegged Currency Regime Ultimate management by governments. Governments directly linking (pegging) their currency’s rate to another currency. Occurs when governments are reluctant to let market forces determine rate. Exchange rate seen as essential to country’s economic development and or trade relationships. Unstable rate associated with potentially unstable domestic financial and economic situation. Impact on inflation (cost of imports) or business activity. Note: As we will see, the distinction between these three categories is sometimes difficult to distinguish.

Examples of Currencies by Regime Floating Rate Currencies: U.S. dollar (1973), Canadian dollar (1970), Euro (1999), British pound (1973), yen (1973), Australian dollar (1985), New Zealand dollar (1985), Thai baht (1997), South Korean Won (1997), Argentina Peso (2002), Malaysian ringgit (2005). Managed Rate Currencies: Singapore dollar, Egyptian pound, Israel shekel, Indian rupee, Chinese Yuan (since July 2005) Pegged Rate Currencies (to the U.S. dollar or market basket) Hong Kong dollar, since 1983 (7.8KGD = 1USD), Saudi Arabia riyal (3.75SAR = 1USD), Oman rial (0.385OMR = 1USD) Note: The distinction between float, managed and pegged is often difficult to see. Chinese yuan can “float” no more than 0.03% per day. For currency symbols see: http://www.xe.com/symbols.htm#list

Floating Currencies Private market forces determine these exchange rates. Financial institutions (global banks, investment firms), multinational firms, speculators (hedge funds), exporters, importers, etc. Market forces originate from two possible sources: Real factors Demand and supply for currencies by global businesses relating to their global commercial activities. Investment/Speculation Entities involved on their own behalf; taking positions with and against currencies: Hedge funds, commercial banks…

Floating Currencies Governments using floating rate regimes historically intervened under “extreme” market forces circumstances. Essentially intervention is buying or selling currency on fx markets. Occurred if a situation produced exchange rate volatility which was seen as too disruptive to financial market stability. For example, U.S. intervened immediately after the attempted assassination of President Reagan on March 30, 1981. But did NOT around the 9/11/2001 terrorist attack. Major countries have gotten out of currency intervention U.S. has been out of the intervention market for a long time (only two interventions in the 1990s; last intervention in 1998) as has the U.K. Japan recently moved away (March 2004). Why? Historical record on intervention by major central banks is mixed and long term intervention is seen as very costly.

Currency Intervention: A Mixed Record Date Players Goal Result Sept 1985 U.S., U.K. Weaken $ Success: Japan, France $ falls 18% Germany within year Feb 1987 G7 Stabilize $ Failure: $ falls 10% within year. Sept 1992 UK Maintain £ Failure: in ERM ₤ out of ERM within days.

Currency Intervention: A Mixed Record Date Players Goal Result July 1995 Japan, U.S. Halt rising ¥ Success: ¥ drops 26% within a year. June 1998 Japan, U.S. Strengthen ¥ Success: ¥ rises 17%

Monitoring FX Intervention Most major central banks provide timely information regarding their intervention activities in foreign exchange markets. As on example see: http://www.ny.frb.org/markets/foreignex.html This site provides a quarterly report on both the U.S. dollar and intervention activities on behalf of the dollar. Go to archives, July 30, 1998 to view intervention activity.

Simplified Model of Floating Exchange Rates (Market Determined Rates) The market “equilibrium” exchange rate at any point in time can be represented by the point at which the demand for and supply of a particular foreign currency produces a market clearing price, or: Supply (of a certain FX) Price Demand (for a certain FX) Quantity of FX

Simplified Model: Strengthening FX Any situation that increases the demand (d to d’) for a given currency will exert upward pressure on that currency’s exchange rate (price). Any situation that decreases the supply (s to s’) of a given currency will exert upward pressure on that currency’s exchange rate (price). s s’ s p p d d’ d q q

Factors Increasing the Demand for a Currency and/or Decreasing the Supply of Dollars What do you think these might be? Increase demand for U.S. dollars (Hint: comes from foreign sources): Decrease supply for U.S. dollars (Hint: results from U.S. sources):

Simplified Model: Weakening FX Any situation that decreases the demand (d to d’) for a given currency will exert downward pressure on that currency’s exchange rate (price). Any situation that increases the supply (s to s’) of a given currency will exert downward pressure on that currency’s exchange rate (price). s s s’ p p d’ d d q q

Factors Decreasing the Demand for a Currency and/or Increasing the Supply of U.S. Dollars What do you think these might be? Decrease demand for U.S. dollars (Hint: comes from foreign sources). Increase supply for U.S. dollars (Hint: results from U.S. sources):

Factors That Affect the Equilibrium Exchange Rate: Floating Rate Regime Relative rates of (short-term) interest. Affects the demand for financial assets. Relative rates of inflation. Affects the demand for real assets. Relative economic growth rates. Affects longer term investment flows in real assets and financial assets (stocks and bonds). Relative political and economic risk. Markets prefer less riskier assets.

What’s What in Japan’s Financial System, 1988; Explaining the Exchange Rate

Issues of Floating Currencies Present the greatest ongoing risk for global firms. Why? Difficult to predict their long term trends (and changes in trends) and shorter term movements. Difficult to predict changes in demand and supply. Long term trend change implications: This complicates the longer term FDI location decision (impact on costs and revenues in home currency). Where should you set up your production facilities? International capital budgeting decision.

Trend Changes: Pound Against the U. S Trend Changes: Pound Against the U.S. Dollar, January 1997 to August 2006 1999-2002: -12%; 2002 – 2005: +31%

Discussion Slide Look at the previous slide and offer explanations as to why the pound: Weakened from 1999 to 2000 Strengthened from 2000 to 2004 Note: Use demand and supply model developed earlier in this lecture.

Issues of Floating Currencies Data also show that these currencies are potentially very volatile over the short term (e.g., day to day basis). Subject to large percentage changes resulting from demand and supply swings. Especially now that governments are staying out of the market. Complicates doing business on an ongoing basis for: Exporters, importers, overseas subsidiaries. What will be the costs and returns associated with different markets? Thus, global firms need to pay close attention to their floating currency exposures and utilize appropriate risk management tools.

Observed Short Term Volatility of the Pound: The last 91 days

Managed Currencies (Dirty Float) Governments intervening in foreign exchange markets to manage their currency to offset (or moderate) market forces. When demand factors or supply factors are seen as creating undesirable exchange rate moves. Affect a country’s trade balance, rate of inflation, etc. Management may occur on a daily basis or only when governments feel conditions warrant their intervention. Intervention commonly referred to as currency “support” policies. These interventions are likely to be used by emerging countries.

Managed Currencies Why do some emerging country government’s manage their currencies? Issue of Weak Currency Concern of Government: Price of imported goods will rise; may cause domestic inflation. Issue of a Strong Currency Concern of Government: Exports will become too costly overseas; a country will lose overseas markets; slow down exports and reduce economic growth (higher unemployment).

Managed Currencies: Direct Intervention Policy Intervention policy when a currency becomes “too weak” Government will buy their currency in foreign exchange markets Create demand and push price up. Intervention policy when a currency becomes “too strong” Government will sell their currency in foreign exchange markets Increase supply to bring price down.

Empirical Findings of Intervention by Emerging/Developing Countries Conclusion: Many emerging/developing countries still intervene in foreign exchange markets to influence currency values. A survey of emerging/developing countries showed that: One third intervene regularly (more than 50% of trading days). Most central banks felt that intervention was more effective in influencing the fx rate over short periods of time: 2 to three days to one week.

Managed Currencies: Interest Rate Adjustments Some countries also use interest rate adjustments to manage their currencies. When a currency become “too weak:” Governments will raise short term interest rates to attract short term foreign capital inflows. When a currency becomes “too strong:” Governments will lower short term interest rates to discourage short term foreign capital inflows. What is the potential problem with this policy?

Managed Currencies Long term, somewhat risky for global firms But not as risky as floating currencies. These currencies are subject to trend moves and trend changes (similar to floating rate currencies). But since these moves are being “managed” they are generally likely to be more gradual. Still, global companies need to assess exposure and risk, over the intermediate term and long term. Trend changes will affect their FDI positions and longer term export and import situations

Longer term Trend Changes in the Singapore dollar (Inverted Scale) 1999 - 2002: - 9%; 2002-2006: +12%

Managed Currencies Over the short term, these currencies are not likely to be as volatile as floating currencies. Reason: Government management tends to moderate short term volatility. Thus daily and weekly changes are not potentially as great as with floating rate currencies. Thus, there is some risk here, but not potentially as great as with a floating rate regime. Potential issue: If governments are managing their currencies within ranges which markets feel are inappropriate, these currencies may come under attack. Successful attacks can quickly alter a currency’s exchange rate. See next lecture slide series for currency attacks.

Observed Short Term Volatility of the Singapore dollar : The last 91 days

Pegged Currencies: Ultimate Currency Management Governments link their national currency to a key international currency (usually the dollar or some combination of currencies). Why? Seen as a necessary condition to promote confidence in the currency and in the country. May encourage foreign direct investment. Seen as important to promoting economic growth. Through supporting the country’s export sector; setting an undervalued currency.

Pegged Currencies Governments maintain pegs through very tight financial market controls, such as: Controlling who participates in the currency market Using licenses Controlling the type of exchange transactions allowed. Not allowing speculative transactions. Only allowing real factor transactions Restricting capital account transactions. Capital outflows and inflows Restricting the daily change in the exchange rate Ongoing intervention in foreign exchange markets to maintain peg.

Pegged Currencies Smallest daily risk to global firms. But firms must be on the alert for potential changes! Countries can either (1) abandon the peg or (2) adjust the peg. These changes do occur either by Government’s orderly change in the peg. Peg coming under successful market attack. Peg changes can have a substantial impact on the financial situation for the global firm when they do occur. Especially if the firm did not take advanced steps to protect itself.

Saudi Arabian Riyal, 1999 - Present

Observed Short Term Volatility of the Riyal : The last 91 days

Argentina Peso: Pegged Currency, 1996 to December 2001

Argentina: Abandoning the Peg – Moving to a Floating Regime: Jan 2002

Abandoning a Pegged Rate and the Currency Weakens: RISKS for Global Firms As noted, these changes in exchange rate regimes pose potential risks for global firms. What do you think happened to foreign multinationals located in and selling in Argentina after the peso weakened? For Example: McDonalds’ profits in Argentina? What do you think happened to foreign multinationals exporting to Argentina after the peso weakened? For example: Boeing exporting airplanes to Argentina?

Abandoning a Pegged Rate and the Currency Weakens: OPPORTUNITIES for Global Firms Changes in exchange rate regimes also offer potential opportunities for global firms. What do you think happened to foreign multinationals importing from Argentina after the peso weakened? For Example: Wal-Mart importing goods from Argentina? What do you think happened to foreign multinationals considering expanding FDI into Argentina after the peso weakened? For Example: The cost for Ford setting up a production facility in Argentina?

China’s Currency Regime: 1978 -2005 In late 1978, the Chinese government began moving its economy from a centrally planned to a market-based system. As part of this process, in 1994, China's central bank linked the yuan (also known as the renmimbi, or "people's money“) to the U.S. dollar. Peg was set at 8.28 to the U.S. dollar

China Moves to a Managed Float July 21, 2005, government announced it was moving to a managed float with an immediate adjustment of the rate to 8.11 Represented a strengthening of the currency, by 2.0% against the U.S. dollar. Regime is now a managed float against a market basket of currencies (including the U.S. dollar, Euro and Japanese yen). Government will manage the yuan within a daily trading range of 0.03% against this basket. The 0.03% range is established each trading day based on the previous close.

Chinese Yuan Before And After Regime Change

Longest Running Peg: Hong Kong Dollar; October 1983 – Present @ HKD7 Longest Running Peg: Hong Kong Dollar; October 1983 – Present @ HKD7.8/USD

Web Sites for Foreign Exchange Rates Intra-day quotes (and charts) http://www.fxstreet.com/ Historical Data (and charts) University of British Columbia http://fx.sauder.ubc.ca/ More Historical Data Federal Reserve Board http://www.federalreserve.gov/releases/ Daily commentary and analysis http://www.cnb.com/business/international/fxfiles/fxarchive/fxarchive.asp